For multinational companies, it is increasingly common to move key employees in and out of different countries – a practice that can trigger a variety of issues. New regulations proposed in February offer some relief for companies with an international workforce, as they indicate that most non-U.S. pension plans will be treated by the U.S. as “deemed compliant” with Foreign Account Tax Compliance Act (FATCA). But multinational employers still have reasons to look closely at pension-based U.S. tax liabilities affecting mobile employees.

There are many issues around a “mobile” workforce, including pay levels, immigration status, moving families and career planning. One small, but increasingly troublesome aspect of a company’s international operations and employee mobility problems involves pensions and retirement plans. The issues in this area have existed for a long time, but will not go away, notwithstanding treaty changes and favorable regulatory developments. But in at least one area, the application to pension and retirement plans of the Foreign Account Tax Compliance Act seems to have settled on a reasonable approach for some entities, based on the proposed regulations that came out in early 2012 under this Act. While this is a development to be applauded, other issues will remain. This article looks at the developments in this area from the perspective of financial institutions supporting pension plans, as well as from the perspective of the individuals participating in these plans and the multinational companies sponsoring them.

Background on U.S. Tax Laws and Non-U.S. Pension Plans

The U.S. takes a very parochial view of pensions under U.S. tax law. It starts with the internationally unusual position that U.S. citizens and residents (resident either by physical presence in the U.S. or though immigration status – holding a “green card”) are taxable on worldwide income, without regard to source or residence. The U.S. then applies its domestic tax laws to other countries’ pension and deferred compensation plans. What this means is that a U.S. citizen or resident who works outside the U.S. and is covered by a non-U.S. pension or a supplemental executive retirement plan or “SERP” (a type of nonqualified deferred compensation plan) has to apply U.S. tax laws to the taxation of that pension. For unfunded pensions and SERPs, there are a number of important exceptions under U.S. tax law for foreign plans (for example, under section 409A of the Internal Revenue Code of 1986, as amended (“IRC”) and the regulations). But unfunded plans are not the only retirement plans found in those countries that are the major trading partners to the United States.

For funded plans, the rules are very harsh: the U.S. views all foreign pension plans, including ones registered or approved by the local tax authority, as “nonqualified” for favorable U.S. taxation. This means that if the employee has a “vested” (nonforfeitable) interest in the plan, then the employee has current income while earning the pension, taxable well before anything is paid out. This rule has extremely complicated tax aspects to it, and for many years was not diligently enforced by the IRS. There are some U.S. income tax treaties that reduce, or in some cases eliminate U.S. tax, but these treaty provisions require careful analysis, as well as intricate procedural hurdles for both the employee and the employer in order to get the favorable tax results. The result is that the employees participating in non-U.S. pension plans may well face current tax without any cash and the employer may have reporting and withholding requirements.

Those dealing with the problems of the Australian Superannuation will find this article very interesting.

Let’s look at another situation. Suppose an Australian citizen is sent by the Australian employer to work in the U.S. It may not be clear when sent how long the assignment will last. As is often the case, the Australian would stay in the Australian-funded, mandatory “superannuation” plan. Under complex U.S. tax rules, that Australian may become a U.S. resident on an unpredictable (unpredictable by the employer) date. Once a U.S. resident, the Australian will become taxable by the U.S. on the superannuation plan (without any distribution). There is a U.S.-Australian income tax treaty, but it does not protect tax in this situation. It appears that the FATCA issue is solved for the Australian superannuation plan, but not the problems of reporting, withholding and paying tax that fall on the employer and employee.

For an excellent discussion of the U.S. taxation of the Australian Superannuation see:

Tallen Harper: Understanding superannuation http://t.co/vq1JkAWBld and the U.S. tax consequences. Excellent research

The basic rule of US taxation is that if you earn money you must pay tax on it, regardless of where in the world it originates. The US makes no distinction between the superannuation framework in Australia and any other type of trust arrangement, so this means even though you are not liable for any tax in Australia your superannuation is up for grabs in the US!

To fully undertstand the tax implications it’s important to differentiate between two classes of income here in question.

Firstly under any arrangement, foreign or not, income (dividends, distributions, interest, etc) and realised capital gains (ie. selling shares/units, taking a distribution, etc) are and always will be taxable in the US while you are classed as a resident for tax purposes. That these take place inside the superannuation regulation in Australia is irrelevant for US tax purposes. If you put exactly the same amount of money into say a Managed Trust it would be subject to the same requirement, and in fact most super funds in Australia actually offer non-super products that under the hood go into exactly the same underlying funds. Only in Australia does the regulation around super artificially shield you from these (because the Australian government sees the future benefit of not having you drawing a pension as being worth the current tax liability you would otherwise occur).

The second class is unrealised capital gains – the “income” from the potential value of the growth in your principle that IF you were to “sell” right now would become realised capital gain. In simplistic terms this is the change in current balance you see when you get a statement from your super fund each year.

The really, really bad news is that a conservative reading of the relevant US tax law that applies here says that Australian superannuation is treated as a “non compliant employer retirement scheme”. Basically the US treats any retirement savings arrangement that does not comply with it’s own very narrow definition (essentially 401k) as being a potential tax shield so to prevent money laundering or tax evasion it treats it as if it’s an untaxed bank account. The sticking point appears to be that the Australian Government “refuses” to restrict contributions to employer payroll which it views as a high fraud risk (nevermind there’s a whole reporting and regulatory framework in place precisely to prevent this!).

Under this definition, your taxable liability in a given US calendar tax year is your balance on 31 Dec minus your balance on 1 Jan in that year, regardless of how the the underlying account functions. If your superannuation balance grows at all, you are subject to your full marginal tax rate in the US on that growth. To add insult to injury, you also cannot claim or defer any capital loss that might occur! If you are like me an experienced phenomenal 15-30% growth in the last half of 2013, this is really, really shitty news.

The only bit of light however is that Australian superannuation is somewhat of a grey area in US taxation law because it depends on how you view it. I am told by several experts in this area that a more “liberal” reading of the relevant tax law makes it possible to argue that only the income generating portion of your super balance growth (ie. dividends, interest, distributions) is directly taxable as income, but not capital gains since is subject to capital gains tax. The only way you can be liable for income tax on capital gains is if you realise that gain within 12 months – after that long-term capital gains tax rates apply which get discounted the longer you hold onto them. This actually makes a lot of sense, because if you purchased shares directly or invested in a mutual trust, this is exactly how it would be treated.

The sticking point is the concessional taxation arrangement. The IRS wants to have it’s cake and eat it too because it argues that the foreign country creates the problem by creating a potential tax shield, which then allows the IRS to classify it as risky and thus ignore that very shield. It exempts it’s own 401k because it argues that by only allowing contributions through the employer the employee can’t embezzle funds to avoid income tax and thus avoid income tax.

So how to deal with this?

The advice of my big-name accounting firm engaged by my employer to assist with US tax preparation is to comply with the conservative definition and declare the full balance gain. Other expats I know who receive advice under similar arrangements from other firms also have been advised to do this.

However, I’ve consulted with a number of experts about this issue and the advice is to declare only the income generating portion; getting a statement from your super fund might prove problematic (I used to work on the systems for one such fund and I can tell you they don’t keep this information) but that’s a potentially easier problem to solve than forking out a shit-load of tax.

Both camps off the record point out that there is a large amount of under reporting due to the complexity and grey area of this part of taxation law (whether FBAR will directly impact this still remains to be seen), and also point out that superannuation is generally not part of their standard briefing.

The bottom line is that American citizens abroad may well have to pay tax on non-U.S. pension plans even when no distributions are made.

As you know, a U.S. citizen who is is married to a non-U.S. citizen does not have the benefit of the unlimited marital deduction. Although I recommend the complete article, the following is of particular note:

Are there special rules for married couples?

Yes. The most important one is that the usual limits on lifetime gifts don’t apply. If your spouse is a U.S. citizen, there’s an unlimited marital deduction for most gifts, even if they exceed the annual exclusion amount and you generally are not required to file a return.

A different rubric applies if your spouse is not a U.S. citizen. In that case you must file a gift-tax return if your gifts to him or her total more than $145,000 per year. Additional gifts to a non-citizen spouse count against your $5.34 million basic exclusion and must be reported on the gift-tax return.

As you U.S. tax compliance for “U.S. persons” living outside the United States is very difficult. The reason is that most (if not all of your activities) are considered to be either “foreign” and/or “offshore”. San Francisco tax lawyer Robert Wood recently write a couple of posts that illustrate how the fact of living outside the United States can actually extend the number statures of limitations for an audit. I draw your attention to:

The gist of the posts is explained in the tweets. That said, I recommend reading both of Mr. Wood’s posts/articles. Although they are not written specifically for Americans abroad, they do illustrate how punitive the U.S. Internal Revenue Code is when applied to Americans abroad.